The 2007–2012 global financial crisis is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world.
In recent decades, the too-big-to-fail doctrine made explicit that the U.S. will not let large financial institutions suffer the full brunt of their risk-taking; so, these institutions assumed more risk. And Fed reassurances in the early stages of the housing and credit bubbles, which the now infamous Alan Greenspan offered, just added fuel to the fire. The message emanating from the Fed was clear: don’t worry too much about risk, since Uncle Alan will come to the rescue when things go wrong.
To avoid future panics, governments must learn to tie their hands and let markets punish excessive risk-taking.
For some time, governments saw the crisis as one of liquidity, thus a problem to be handled by the central banks through liquidity provision. In the fall of 2008, it became clear that undercapitalization was a major issue. In October 2008, the United States introduced the “troubled asset relief program'' (TARP), allowing the Treasury to buy assets or inject capital up to $700 billion. A few weeks later, during an important week end in October, with meetings both in Washington and in Paris, major countries agreed to put in place financial programs along the lines sketched above.
John H. Makin, a visiting scholar at the American Enterprise Institute, wrote recently, “If the Lehman Brothers’ failure had not triggered the panic phase of the cycle, some other institutional failure would have done so.” I’ll go a step further: it is quite likely that the financial crisis would have been even worse had Lehman been rescued. Although nobody realized it at the time, Lehman Brothers had to die for the rest of Wall Street to live.
International Responses to the Crisis Timeline (Sept 2008 - June 2010)
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During the borrowing spree, the deficit countries consumed more than they produced and invested more than they saved; now they have to produce more than they consume and save more than they invest; they also have to increase exports and reduce imports. The domestic political economy of this sort of adjustment cannot be popular, involving as it does reduced consumption and lower real wages.
This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital
floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash. In broad outlines, the cycle describes the developing-country debt crisis of the early 1980s, the Mexican crisis of 1994, the East Asian crisis of 1997-1998, the Russian and Brazilian and Turkish and Argentine crises of the late 1990s and into 2000-2001—not to speak of the German crisis of the early 1930s or the American crisis of the early 1890s.
Financial Turmoil Timeline (September 2008 - December 2010)
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Between 2001 and 2007, the American current account deficit averaged between $500 billion and $1 trillion every year, resulting in a current account deficit equal to an unprecedented 6 percent of GDP in 2006
On Monday, Sept. 15, 2008, when the news broke that, despite nonstop efforts that weekend, there would be no last-minute reprieve for Lehman, à la Bear Stearns, all hell broke loose.
The stock market tanked, dropping more than 500 points that day. The Reserve Primary Fund, a money market fund that held Lehman bonds, “broke the buck.” Shortly afterward, the American International Group nearly collapsed, and had to be bailed out with an extraordinary $85 billion loan from the government. Morgan Stanley was rumored to be next. Banks all over Europe were teetering. There were even fears about the stability of mighty Goldman Sachs.
American policymakers are likely to face powerful temptations to address the country’s problems, at least in part, with a bit of inflation and a bit of depreciation. Inflation will reduce the real burden of the country’s enormous debt – both to itself and to others – while depreciation will help reduce the current account deficit. Both measures excite fear in foreigners, both by reducing the real value of their investments in American assets and by reducing their producers’ ability to sell into the American market. Or conflict might emerge in trade policy. Countries desperate to increase exports and reduce imports might embark on aggressive unilateral
moves to force open foreign markets, or attempts to close their own. Again, the response is likely to be hostile, and the results damaging.